Due Diligence

“The return on investment is important, but so is the degree of uncertainty surrounding that return.” – Harry Markowitz – Nobel Laureate in Economics

Until the early 1950s, financial decision-making was dominated by the quest for higher returns, with risk discussed vaguely or sidestepped as an inconvenient aspect of investing. In this context, Harry Markowitz—a young economist at the University of Chicago—introduced the revolutionary concept that investors must consider not just the potential return of an investment, but also the volatility and unpredictability of those returns. He argued—and later mathematically demonstrated—that a rational investor’s core challenge is to balance expected gains against the “degree of uncertainty” or risk inherent in each investment choice.

The breakthrough came with Markowitz’s seminal 1952 article, “Portfolio Selection,” which launched Modern Portfolio Theory (MPT). Markowitz’s insight was to express risk quantitatively using statistical variance and to show that combining assets with differing risk/return profiles—and especially low or negative correlations—can systematically reduce the overall risk of a portfolio. This approach led to the concept of the efficient frontier: a set of mathematically optimal portfolios that define the best possible trade-offs between return and risk.

Markowitz’s framework was foundational not just for portfolio construction but for all of modern investment practice, establishing that proper diversification is the only “free lunch” in finance. His methods for quantifying and managing investment risk, and for rigorously balancing it against potential return, underpin the design of pension funds, institutional asset pools, and mainstream investment advice to this day.

About Harry Markowitz

Harry Markowitz (1927–2023) irreversibly altered the landscape of finance. Growing up in Chicago, he studied physics, mathematics, and economics at the University of Chicago, where he also earned his Ph.D. His interest in the stock market and the application of maths to practical problems led him to challenge accepted investment wisdom, which focused predominantly on individual securities rather than portfolios.

While writing his dissertation, Markowitz recognised a gap: the prevailing view only considered the expected value of investments, neglecting the variability of outcomes. He addressed this by integrating risk (quantified as variance) into the decision-making process. During his time at RAND Corporation and later the Cowles Foundation, he developed optimisation techniques—most notably, the “critical line algorithm”—to identify portfolios delivering the highest expected return for each level of risk.

Throughout his career, Markowitz contributed to computer science (e.g., sparse matrix techniques, Simscript programming language) but is celebrated foremost for his impact on investment theory. His 1959 book, Portfolio Selection: Efficient Diversification of Investments, solidified MPT’s foundational status. Recognition followed: the John von Neumann Theory Prize (1989), the Nobel Prize in Economic Sciences (1990), and broad acclaim as one of the intellectual architects of modern finance.

Leading Theorists and Extensions

After Markowitz established the field, other thinkers extended and enriched portfolio theory, shaping today’s financial landscape:

• James Tobin: In 1958, Tobin advanced MPT by integrating the concept of a “risk-free” asset, demonstrating that all efficient risky portfolios could be crafted as combinations of a risk-free asset and a single optimal risky portfolio—a result known as “two-fund separation.” This idea underpins how institutional portfolios blend asset classes depending on tolerance for risk.

• William F. Sharpe: Sharpe, originally Markowitz’s colleague at RAND, further elevated the framework when he developed the Capital Asset Pricing Model (CAPM) in 1964. CAPM explains how asset prices are determined in equilibrium, introducing the concept of “beta” to measure a security’s risk relative to the market—fundamentally changing both academic theory and investment practice.

• Merton Miller: Miller, who shared the Nobel Prize with Markowitz and Sharpe, contributed crucial insights on capital structure and corporate finance. His collaborative work with Franco Modigliani showed that a firm’s value is not fundamentally improved merely by changing its leverage, but is a direct function of its underlying risk and assets—a result complementary to Markowitz’s work on portfolio risk.

Together, these theorists constructed the mathematical and conceptual scaffolding for virtually all of modern investment, asset pricing, and risk management—today underpinning everything from index funds and robo-advisors to global pension strategies. The central principle endures: investment success must be measured not by returns alone, but by the careful, scientific balancing of reward and risk in an uncertain world.